On risk premium variation

Discussion notes 1 -
18 March 2011

This section provides a brief introduction to modern financial economics and theories of discount factor variation

Main findings

During the last four decades, financial research has moved from striving to understand how new information about future payoffs is incorporated into market prices to striving to account for how and why the discount factor of these payoffs varies over time and across assets. This has profound practical implications. Multiple dimensions of risk with time-varying discount factors potentially open up a more demanding portfolio theory.

The average investor must by necessity hold the market portfolio, but the market portfolio is not necessarily optimal for all investors. Thorough understanding of how own liabilities, own non-traded risks, and careful identification of comparative advantages and disadvantages relative to other investors, might give reasons to pursue dynamic portfolio strategies that differ from those of both the marginal and the average investor.

These strategies might include departures from mean-variance trade-offs, such as engaging in trading strategies which aim at exploiting known premiums in cross-section and time series, e.g. employing value-weighted rebalancing rules.

The analytical framework used by modern financial economics is also shared with modern applied fiscal theory, which, among other things, gives a transparent rationale for the Norwegian government’s fiscal spending rule (“handlingsreglen”).